Banks Try on New Volcker Rule, Like Its Wiggle Room: QuickTake

(Bloomberg) -- Former Federal Reserve Chairman Paul Volcker had a seemingly simple idea for making banks safer after they brought the global economy to the brink of collapse in 2008 and had to be rescued with taxpayer money: Restrict federally insured lenders from engaging in speculative trading that can trigger huge losses. A decade later, his namesake Volcker Rule, authorized by the 2010 Dodd-Frank financial reform law, has turned out to be anything but simple, resulting in lobbying by banks for a major rewrite. The Donald Trump administration agrees, and so do its financial regulators. The Fed and four other regulatory agencies are proposing changes to give banks greater leeway to trade without running afoul of the rule.

1. What was wrong with the original version?

Wall Street hated the 2013 regulation even before the ink was dry. Banks complained that it was almost impossible to decipher which trades were permitted and which were prohibited. While regulators have long signaled they don’t entirely disagree, it wasn’t until Trump’s rule-cutting agenda swept through Washington that watchdogs decided to do something about it. The regulators’ proposal would reduce banks’ compliance costs, tailor regulatory burdens to the size of a bank’s trading book and give lenders more clarity on how to comply.

2. So what’s in the new proposal?

It maintains a ban on proprietary trading (prop trading for short), in which banks invest for their own profit rather than for a customer’s benefit. Regulators, however, would no longer assume that any position held for fewer than 60 days is proprietary. They also would no longer ask traders to certify their intent on a transaction -- a feature the banks loathed because it presumed guilt until trades could be proven allowable. Instead, bank overseers would look to see how a trade appeared on a bank’s financial statements. If labeled a tradable asset -- listed at the current market price, as U.S. Generally Accepted Accounting Principles dictate -- the trade would fall under the prop-trading category.

3. How else would banks gets new wiggle room?

Under the existing rule, short-term trades are permitted if a bank can demonstrate that they were done for market-making purposes, in which they hold instruments in their own inventories to help clients buy or sell when needed. Under the proposal, transactions would be presumed to qualify for the market-making exemption -- that they fulfill customers’ near-term demands -- as long as a bank limits the total financial risk a trading desk can take on. Another existing exemption allows banks to conduct short-term trades if they are done to hedge, or protect, against a potential loss. Lenders of any size -- even the largest, with trading assets and liabilities exceeding $10 billion -- would no longer have to show that such trades “demonstrably” reduce a specific risk.

4. What about smaller banks?

Banks with small- and medium-sized trading operations would be able to take advantage of several carve-outs. And banks with trading portfolios below $10 billion would no longer be required to have an internal compliance program to take advantage of the market-making exemption.

5. The new rules seem more permissive. Are they?

In some ways, the proposal would shift oversight from a system in which a bank must prove its trades are permissible to one where regulators increasingly take the bank’s word for it. Regulators, however, retain the right to look behind a bank’s exemption justifications and compliance claims. Randal Quarles, the Fed’s point person on regulation, says the original version forced every trade to undergo a series of “complex tests that are difficult or impossible to verify in real time.” Jamie Dimon, the JPMorgan Chase & Co. chairman and chief executive officer, once famously quipped that traders would need a psychologist and a lawyer by their sides -- the former to divine intent and the latter to gather the evidence.

6. Will banks start acting like hedge funds again?

Opinions differ. Most regulators say no because proprietary trading remains banned. What’s more, they say, at banks with trading portfolios of $1 billion or more (the Fed says there are about 40 of them, accounting for 98 percent of total bank trading), the CEO still must attest that the rules have been followed. On the other hand, critics say some lenders may feel emboldened to take on more risk now that they have brighter lines between what’s permitted and what’s not. Kara M. Stein, a member of the Securities & Exchange Commission, one of the five agencies involved, said the rewrite “cleverly and carefully euthanizes the Volcker Rule.” Another opponent, Marcus Stanley, policy director at Americans for Financial Reform, which advocates for tougher Wall Street oversight, said the re-do is “an attempt to unravel fundamental elements of the response to the 2008 financial crisis, when banks financed their gambling with taxpayer-insured deposits.”

7. What’s next?

A final rule could slip to the end of the year or even to early 2019. That’s because the five federal agencies responsible -- the Fed, the SEC, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. -- all must publish the proposal for public comment. Before enforcing a new rule, all five must consider comments, weigh alternatives and vote again to adopt any changes to make the joint proposal binding.

The Reference Shelf

  • The Federal Reserve’s release on the proposed rule.
  • A QuickTake explainer on how what Trump might mean for Wall Street reform.
  • Davis Polk’s Volcker Rule website has the proposed rule text and other commentary.
  • A summary of the 2010 Dodd-Frank Act.
  • In 2010, Volcker voiced dissatisfaction with the regulations being developed.
  • Volcker’s comment letter on the original proposal.

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